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How to Spot a Value Trap: Research in Motion

Question: When looking at cheaply-priced stocks, how do you know which ones are solid value stocks and which ones are dreaded value traps?

Answer: The value stocks eventually recover, whereas the value traps do not.

I realize that my answer is no more useful than Will Rogers’ advice to “Buy stocks that go up; if they don’t go up, don’t buy them,” and that is precisely my point. There is no systematic way to recognize a value trap.

Some sectors are more prone to value traps than others, and this is something I’ll elaborate on later in the article. But first I’ll give an example of a value trap that ensnared yours truly—BlackBerry maker Research in Motion ($RIMM).

When I first started considering RIMM last July, it was one of the cheapest companies in the world. At one point in time it traded for just 3 times earnings and barely half its book value.

My thinking when I bought RIMM was straightforward enough. While the company was losing the smart phone war to Apple ($AAPL) and Google ($GOOG), it had a strong and growing services business with sticky revenues, a strong and growing presence in emerging markets, and a rock-solid balance sheet. Yes, the company was losing market share, but its sales were still growing and a decent clip. At the price at which it traded, RIMM didn’t have to win the smart phone war in order to be a good investment; it merely had to survive.

In most industries, this would have been sound thinking and the makings of a great contrarian investment. But in technology, where platforms are everything, it doesn’t hold. Much like the Game of Thrones, with technology platforms you win or you die

Shrinking market share for your platform begets further shrinking market share. Retailers don’t want to take up shelf space better used for more popular products. Carriers don’t want to offer incentives. Programmers don’t want to write applications for a shrinking platform. Rather than a gentle decline, you get a sudden collapse.

Case in point RIMM. With the BlackBerry, RIMM invented the smartphone as we think of it today and quickly rose to dominance. After conquering the corporate and government markets, the success of the BlackBerry spilled over into the consumer market. BlackBerries became known as “CrackBerries” for their addictiveness. As recently as 2010, RIMM held nearly half of the smartphone market, only to see that market share shrink to single digits today.

Believe it or not, I do believe that RIMM has a future. But its future lies as a software and services company, providing enterprise e-mail, messaging and security, and not as a hardware maker. A slimmed down services-only RIMM would be worth owning at the right price. But before that happens, management will likely destroy quite a bit more value attempting to salvage their hardware and operating system.

Not all cheap tech companies are value traps, of course. Microsoft ($MSFT) and Intel ($INTC) have both been cheap for years, though both have strong underlying businesses nearly impervious to competition and both have been rewarding shareholders with a high and growing dividend.

As much as we would like for it to be, this is not an exact science, and you’re not going to get it right every time. In the end, the best defense against a value trap is emotional discipline. Look at your investments critically and don’t make excuses when they fail to perform. Use stop losses when appropriate. And be honest with yourself when you ask the question, “If I didn’t already own this stock, is this something I would want to buy today, knowing what I know?”

Oh, and follow Will Rogers advice about avoiding stocks that don’t go up.

Disclosures: Sizemore Capital is long INTC and MSFT. Alas, we were formerly long RIMM.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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What Says the Investing All-Star Team?

I’ll let you in on a little secret, dear reader. In those moments when I have doubts, I like to look over the shoulders of great investors to see what they are doing. (Actually, it’s really not much of a secret. It’s a topic I discuss quite openly and frequently. See “When in Doubt, Follow the Greats.”)

Back in grammar school, your teacher might have called it “cheating,” but this isn’t grammar school. It’s the rough-and-tumble real world of investing, and we can all learn a lot from following the trades of great investors.

Every year in January, Barron’s assembles an “all-star team” of sorts to participate in their Roundtable discussion. The 2012 team includes familiar names such as Pimco founder Bill Gross, Gloom, Boom & Doom Report Editor Marc Faber, and Senior Investment Strategist of Goldman Sachs Abby Joseph Cohen.

In the June 9 issue of the magazine, Barron’s checked up on the Roundtable to get their investment outlook in light of the turbulence coming out of Europe (see “Caution: Sharp Turns Ahead.”)

Views among the ten panelists run the gamut, but a couple themes showed up with consistency.

  1. Europe’s sovereign debt crisis continues to be the single biggest threat to both the global economy and the capital markets.
  2. China’s slowdown is also a major concern.
  3. The United States—while healthy by comparison—faces the “fiscal cliff” of tax hikes and spending cuts next year barring a deal between the White House and Congress.

The panelists might as well have added that the sky is blue, as these conclusions will come as a surprise to no one. Still, their recommendations for how to navigate the storm are varied and insightful.

Felix Zulauf, President of Zulauf Asset Management, is the most bearish of the bunch. Zulauf notes that stocks are cheap—adjusted for inflation, Italian stocks trade at “levels last seen in Mussolini’s era”—yet that does not guarantee good returns going forward. Zulauf sees the West more or less caving in on itself under the weights of its debts.

Abby Joseph Cohen notes that “Individual investors have had the stuffing knocked out of them” in recent years, which explains their skittishness. No one wants to sit through another 2008 meltdown, so investors tend to sell first and ask questions later.

This has created bargains, however. Like Zulauf, Cohen considers stocks to be cheap by historical standards: “Stocks are selling at low price/earnings ratios [and] companies have strong balance sheets.”

Of course, as Cohen notes, this means nothing in the short-term. Stocks can go from cheap to cheaper.

Meryl Witmer, General Partner of Eagle Capital Partners, has the views closest to my own. Says Witmer, “The exodus from the market has created bargains. You have to stay unemotional and analytical and try to find companies that, in the long run, will generate free cash and increase in value. Usually, when stocks get cheap like this, things get better.”

Witmer takes a play out of Warren Buffett’s book, arguing that you should only buy a company “if the market were to close for 10 years, you would still be happy owning that company.”

I will note that when I have made the biggest mistakes in my investing career, it is usually because I failed to take that advice. You don’t have to actually hold the stock for ten years. You should just make sure that everything you own is something you’d be willing to hold for ten years if the market were to close tomorrow. It’s a sound rule of thumb.

Bill Gross’s comments were particularly interesting. For a man known around the world as the “Bond King,” Mr. Gross is not at all bullish on bonds, noting that “Treasuries are overvalued and getting more so.”

Gross sees roughly a decade ahead of slow growth with the economy on central bank monetary “life support.” Yet he is bullish on select emerging market bonds and, interestingly, Sizemore Investment Letter recommendation Siemens ($SI) and French pharmaceutical giant Sanofi ($SNY)—both European companies in the heart of the sovereign debt crisis.

I’ll wrap this up with comments from “Dr. Doom” Marc Faber.

Faber, uncharacteristically, is surprisingly light on the doom and gloom. Though he expects things to get worse before they get better, he believes that “stock markets are oversold” and that “the U.S. bond market is overbought.”

Not surprisingly, Faber likes gold. He’s a long-time gold bug. But rather than recommend investing in a bunker in Idaho, Faber also likes Singapore REITS at current prices, as well as select European blue chips—including Sizemore Investment Letter recommendation Nestle ($NSRGY).

So there you have it. The All Star team is cautious, but they’re not exactly running for the hills either. By and large, they are recommending selective buying on dips, particularly of high-quality, dividend-focused equities.

Sound advice, I would say.

Disclosures: SI and NSRGY are Sizemore Capital holdings.  This article first appeared on MarketWatch.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Diageo: The Ultimate 12- to 18-Year Play

Have you ever noticed that new “premium” vodka brands seem to pop up every other year, yet the quality scotch brands you see on shelves today are the same ones you might have seen in your grandfather’s liquor cabinet?

There is a reason for that. Vodka is colorless, flavorless and can be mass produced from scratch in a matter of days. For that matter, you can make it in your bathtub over a long weekend with basic ingredients from your kitchen.

Making an enjoyable scotch, on the other hand, takes years. In fact, whisky cannot technically be called “scotch” at all unless it has been aged in an oak cask for a minimum of three years.

Of course, if you offer a gentleman a scotch that has only been aged three years, he might take it as an insult. A decent scotch—be it blended or single malt—will generally be aged anywhere from 12 to 25 years or more.

Anyone can start an exclusive new vodka brand given a sufficient pool of capital. Consider the example of Grey Goose. The American billionaire Sidney Frank created the brand in 1997 and sold it to Bacardi just seven years later for a quick $2 billion. Had he opted instead to create a new scotch brand, he would not have lived long enough to enjoy its success. When the late Mr. Frank passed away in 2006, his first batch of scotch would have still needed another 5 years or more of aging to be taken seriously.

This is a significant barrier to entry for would-be newcomers. Imagine an enterprising scotch enthusiast attempting to start his own distillery today. What bank or venture capital firm would put up the money to get a distillery of any size in production given that the company wouldn’t have a sellable product for at least a decade?

Perhaps you could get the enterprise off the ground faster by buying existing aged inventory from a small independent distillery, but this is not something that would be feasible on an industrial scale. At best you would have a small craft business.

This brings me to a recent headline on Diageo (NYSE:$DEO) the British-based international spirits conglomerate and owner of the ubiquitous Jonnie Walker brand. In addition to Johnnie Walker, Diageo owns the J&B scotch, Crown Royale Canadian whiskey, Ketel One and Smirnoff vodka, Jose Cuervo tequila, and Bailey’s Irish Cream brands (among many others) and acts as distributor for the assorted cognacs of Moet Hennessy.

Diageo is investing $1.5 billion to expand its scotch production over the next five years. The news sent shares of Diageo’s stock price higher as investors interpreted the announcement as a bullish call on the company’s future.

Think about it. Diageo’s management must feel pretty confident about the future to expand its scotch operations on a grand scale. While some of the production used for the lower end Red Label line might be available in as little as 3-5 years, it will be at least 12 years before any whisky made in the new distilleries will be eligible to be used in a bottle of Black Label—and nearly three decades before it could be used in a bottle of the ultra-high-end Blue Label.

I have every reason to believe that this optimism is warranted. Over the past 5 years, the company has grown its top-line sales by over 50 percent—and the past five years have been rather challenging for most consumer-related businesses.

Much of this growth has been due to high demand from emerging markets—which already constitute 40 percent of Diageo’s sales and continue to take a bigger slice every year.

Call it the legacy of the British Empire. The United Kingdom controlled 25 percent of the world’s land mass at its apogee, and its influence spread far wider. And everywhere those ambitious British colonials went, they brought with them a thirst for scotch whisky. Outside of the United States—where Kentucky bourbon whiskey and Tennessee whiskey are popular—scotch is generally the only game in town.

As incomes continue to rise in China, India, Latin America and other brand-conscious emerging markets, so do standards of taste. Ordering a premium spirit or offering a bottle as a gift is a sign that you have “made it” in life. This is a long-term macro theme with decades left to run—which is perfect for Diageo’s premium scotch production timeline.

I should also add that Diageo is an International Dividend Achiever, meaning that the company has raised its dividend for a minimum of five consecutive years. I expect Diageo to continue raising its dividend at a nice clip in the years ahead. The stock currently yields 3.0 percent.

I won’t say this about too many companies, but Diageo is a stock that you can buy and forget. I recommend the stock for your core, long-term portfolio—and I also recommend you take the time to enjoy a bottle of Black Label, preferable with full-bodied cigar. And if Diageo performs as I expect, use your dividend proceeds to upgrade to a bottle of Blue Label.

Disclosures: Sizemore Capital is currently long DEO. This article first appeared on InvestorPlace.

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Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Trading Strategies: Playing Europe in the Near Term

The most annoying thing about old Wall Street adages like “Sell in May, go away” is that once in a while, they are actually true.

Sure, most of the time it makes sense to be invested during the summer months.  If history is any guide, they are more likely to be positive than negative.  But in recent years, the summer months have been choppy and volatile and investors would have been well-served to, as the saying goes, sell in May.

This year, “sell in April” might have been better advice.  After a monster first-quarter rally, fears of a Eurozone meltdown have caused the market to give back most of its gains.

But is the pervasive fear justified?  And could Europe really be headed for a 2008-caliber meltdown?

The short answer is “no,” though this requires a little explaining.

What happened in 2008 was the modern-day equivalent of an old-fashioned bank run, a crisis of confidence.  When Lehman’s counterparties lost faith in the bank’s abilities to honor its commitments, it set into motion a chain of events that would have taken down virtually every major global bank had the Fed not stepped in and made emergency liquidity available.

The ECB learned a thing or two from watching the Fed improvise.  There would be no “Lehman Brothers moment” in Europe.  Bank failures, if they were to happen, would be orderly.  This is what prompted the ECB’s LTRO program, which European banks used to borrow over a €1 trillion.  The ECB also proved itself willing to stabilize the Spanish and Italian bond markets with aggressive open-market operations when needed.

But what about Greece?

What about it.  By the time this article goes to press, Greece might have already defaulted and been booted out of the Eurozone.  And if not, it will be only a matter of time.

The standard line on Greece is that its default will create a market crisis that will cause the rest of the Eurozone problem states to fall like dominoes.  Well, this could be the case.  But if so, it would be the most anticipated crash in history.  And highly-anticipated market events have a funny way of not happening.

Given the absolute carnage in European stock markets, I have a hard time believing that most of the selling hasn’t already been done.  A “Grexit” might prove to be a non-factor or, in true contrarian fashion, actually cause world markets to rally.

Still, I admit that I’ve consistently underestimated the severity of the European sovereign debt crisis, and I have to accept that my premise—that cooler heads will prevail and that Germany and the ECB will do what needs to be done to avert catastrophe—may prove to be far too optimistic.  This could get a lot worse  before it gets better if investors’ worst fears turn into a self-fulfilling prophecy.

With all of this said, how should investors position their portfolios this summer?

In my view, the market looks like a coiled spring ready to pop.  The combination of excessive bearishness among investors, cheap pricing across most sectors, and a lack of attractive investment alternatives makes me believe that we’re in the midst of a fantastic buying opportunity.

But given the nagging possibility of a deep market swoon, it also makes sense to keep a little more cash on hand than usual.

I would be comfortable with a portfolio that is about 75% invested in high-quality, dividend-paying stocks.  As a nice rule of thumb, I’d like to see companies that have raised their dividends for a minimum of 5-10 consecutive years.

My reasoning here is easy enough to understand.  A company that was able to raise its dividend throughout the turmoil of the past 5 years is a company you know can survive Armageddon because frankly, it already has.

For a good fishing pond of high-quality dividend payers, check out the holdings of the Vanguard Dividend Appreciation ETF (NYSE:$VIG).  It’s loaded with blue chips like Wal-Mart (NYSE:$WMT), Coca-Cola (NYSE:$KO) and McDonalds (NYSE:$MCD) among many other household names.

If the market turns around as I expect, VIG should enjoy roughly the same upside as the broader S&P 500.  But if I’m wrong and the market takes a swan dive, you can at least rest easy knowing that you’re holding a portfolio of stocks that will almost certainly continue to raise their dividends in the years ahead. And you’ll enjoy a cash return that is better than what you would have gotten had you left your funds in Treasuries or in the bank.

And for the roughly 25% you hold in cash, I have a few recommendations for that as well.

In a recent article (See “How to Invest for a European Armageddon”), I suggested selling out-of-the-money puts on some of Europe’s battered blue chips.  But if this is too complicated, simply dripping into high-quality names on dips will work nearly as well.  I mentioned Spanish-listed Telefonica (NYSE: $TEF) and Banco Santander (NYSE:$STD) and I continue to view both as attractive today.

Disclosures: Sizemore Capital is long VIG, WMT and TEF.

This article first appeared on MarketWatch as part of the Trading Strategies series.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Europe Reaching the Boiling Point: How to Invest

For a year that started with one of the best first quarters in history, the second quarter has proven to be something of a disappointment.

On the first trading day of June, the U.S. averages had their worst performance of 2012, pushing the Dow Industrials into negative territory for the year. The S&P 500 is still positive for the year…albeit barely.

Interestingly, Spanish stocks—which have been at the center of the European financial crisis that has been roiling the markets—finished the day roughly flat. Sizemore Capital continues to allocate funds to select Spanish stocks, and the relative calm in the Spanish market gives us hope that much of the selling there has already been done. Spain is home to some of the world’s finest multi-national companies, and the state of crisis has created absolute steals that we may not see again in our lifetimes.

The Sizemore Investment Letter Portfolio holds positions in Telefonica (NYSE:$TEF) and Banco Santander (NYSE:$STD) and has additionally sold out-of-the-money puts on both. (See “How to Keep Your Cool While Investing in Europe” for more details on our put strategy.) Additionally, the Tactical ETF Portfolio holds a position in the iShares MSCI Spain Index ETF (NYSE:$EWP).

More than even bad news, markets hate uncertainty. And the uncertainly about the Eurozone’s future has wreaked absolute havoc on Spanish and European shares.

Spain’s effective nationalization of the ailing Bankia—the country’s third largest bank by deposits—had precisely the opposite effect of what you might have expected. Rather than cheer the fact that the Spanish government is taking the crisis seriously, it simply raised new questions about the Spanish state’s ability to afford the bailout of its banking sector.

The way forward is becoming increasingly obvious. As The Economist wrote this week, “Spain’s problem is one of misdiagnosis.”

The focus of the Spanish government and of the broader European Union (and particularly Germany) has been austerity. The thinking is that budget deficits must be slashed in order to restore investor confidence. The case of the United States—where both debts and deficits are higher than in many of the EU’s problem states—proves that this is not entirely true. After all, the yield on the 10-year Treasury note recently hit levels not seen since World War II.

As The Economist continues,

“This fiscal focus gets things exactly backwards. Spain’s poor public finances, unlike those of Greece, are a symptom rather than the cause of the country’s economic woes. Before the crisis Spain was well within the euro zone’s fiscal rules. Even now its government debt, at around 70% of GDP, is lower than Germany’s.”

In Spain, it is all about the banks. Outside of Santandar and Banco Bilbao Vizcaya Argentaria (NYSE:$BBVA), Spain’s banks are by and large insolvent and in need of recapitalization.

Again, using The Economist’s figures, a recapitalization of €100 billion would be roughly 10% of Spain’s GDP. Borrowing this amount would still leave Spain safely below the debt-to-GDP levels of the United States, but the country would have to pay punishingly high rates of interest given current market conditions.

On a side note, the Financial Times estimates the cost of a banking bailout to be much smaller. The FT points out that roughly 11% of Spanish bank loans are non-performing, which is less than half the level of Ireland, the country whose predicament most closely matches that of Spain. At 350% of GDP, Spain’s banking assets are large by world standards, but again, less than half the levels of Ireland.

What is the most likely solution? The budding consensus would seem to be using EU rescue funds to inject capital into the banks directly, which Spain is now advocating.

Currently, this is not legal under EU rules. But as the last year and half of on-again / off-again crisis has proven, EU rules are a bit of a work in process.

In any event, the next week promises to be anything if not interesting. Mariano Rajoy, Spain’s prime minister, publicly announced support for EU oversight of national budgets, apparently in an attempt to sweet talk German chancellor Angela Merkel. Separately, the European Central Bank indicated over the weekend that it was “prepared” to intervene with bond purchases or additional bank assistance if needed. And encouragingly, late last week, the EU announced that it would be lenient in allowing Spain another year to get its budget deficits under control.

What does all of this mean to us as investors? In investing, as in many of life’s endeavors, it is always darkest just before the light. And it would appear that we’re starting to see a sunrise in Europe. Sizemore Capital will look for opportunities in the weeks ahead to profit from the resolution of Europe’s crisis.

 This article was originally published as Sizemore Capital’s monthly market commentary for Covestor.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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